My column for the Tennessean this week is the third in a series on managing cash flow:
My previous two columns have examined why the phrase “cash is king” is so true and what steps entrepreneurs can take to improve their cash flow.
So what is the purpose of building up cash reserves? Think of your cash reserves as four pools of funding with four distinct purposes.
The first pool of cash is to plan for those large expenses that are not part of regular monthly expenses, but are critical nonetheless. Examples are quarterly tax payments, annual equipment replacement purchases, or large seasonal marketing campaigns.
Create a calendar of these payments and put cash aside to build up enough to cover them.
The second pool of cash is used to better manage the natural “lumpiness” of cash flow. The reality is that the rate that cash flows into a business is never smooth and predictable. Some businesses have to pay for products to be made or for services to be provided well before they actually get paid. Other businesses may have seasonal sales swings, such as many retail businesses that have most of their sales in November and December.
This second pool of cash should be used to create your own internal line of credit to help navigate the natural “lumpiness” of cash flow.
Be ready for the unexpected
Think of the third pool of cash as your emergency fund. This pool should be large enough to cover at least a month of day-to-day expenses. This will help cushion you from events such as an unexpected loss of a major customer or a major disruption of your business.
I remember one year in our health-care company when we lost about two weeks of sales in the aftermath of a hurricane in September, followed by the loss of about 10 days of sales due to a major ice storm in January. Cash reserves are what got us through those tough times.
The final pool of cash is for an “opportunity war chest.”
Recessions create many opportunities for financially strong companies. There may be opportunities to acquire a competitor’s business that’s been weakened by the economy or to expand and fill the void left by a competitor’s failure.
It may actually prove to be a good time to expand the business — real estate prices, the cost to rent space, equipment expenses and labor costs will all be lower.
Develop an annual plan to forecast all of the needs for a cash reserve.
Create a separate bank account to keep these funds segregated from the cash needed for day-to-day operations.
And make regular and frequent transfers into this account whenever possible to ensure that the funds will be available when you need them.